Institutional grade commercial properties are very expensive, which means they are rarely purchased and managed by a single investor. Instead, they tend to be purchased by multi-member groups like partnerships or LLCs. While this structure is very helpful to facilitate the purchase of a large asset, they can become difficult to manage when trying to complete a 1031 Exchange.
In this article, we are going to answer the question – can real estate investors complete a 1031 Exchange on jointly owned properties? In doing so, we will describe what a 1031 Exchange is, the rules for completing one, the benefits of doing so, and how they can work with jointly owned properties. By the end, readers will have the information needed to determine if a 1031 Exchange with a jointly owned property is the right fit for their own investment strategy.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. In doing so, we frequently help investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about how we can help with a 1031 Exchange, click here.
What is a 1031 Exchange?
A 1031 Exchange, sometimes called a Like Kind Exchange or Delayed Exchange, is a commercial real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into another like kind property.
A “like kind” exchange property is one that has the same nature of character as the one that was sold. In general, most commercial property types are like kind to other commercial properties. For example, a retail center is like kind to a multifamily rental property as long as they are both held for investment.
How Does a 1031 Exchange Work?
At a high level, a 1031 Exchange is completed in three steps.
First, a real estate investor identifies a property that they would like to sell, this is known as the Relinquished Property. Often, they will hire a real estate broker and, ideally, they are able to sell the property for a price that is higher than what they paid. When they do, this is known as a taxable gain.
Second, to defer taxes on the gain, investors must identify a replacement property that they intend to purchase. Under Internal Revenue Service (IRS) rules, the replacement property must be like kind and held for investment purposes. So, for example, an investor could not attempt to exchange their primary residence for an office building.
Third, once the replacement property is identified, investors must close on the purchase of it. Once the purchase is complete, so is the exchange.
Key 1031 Exchange Rules
To complete this transaction and receive full tax deferral, investors must comply with a number of rules that are outlined in Internal Revenue Code section 1031. While there are many of them, there are four that are are noteworthy for the purposes of this article:
- Investors have a 45 day period of time, from the sale of the relinquished property, to identify a suitable replacement property.
- Investors have 180 days from the day the relinquished property is sold to complete the purchase of the replacement property.
- The replacement property’s fair market value/sales price must be equal to or greater than the value of the relinquished property.
- Perhaps most importantly as it relates to the topic of this article, the taxpayer on the title of the old property must be the same as the taxpayer on the title of the replacement property.
In theory, the property title rule is fairly straightforward. But, it can present complications when there are multiple members of the ownership group and some want to complete a 1031 Exchange and others do not.
Issues with 1031 Exchanges & Multiple Property Owners
When there are multiple property owners there are several issues that can arise then attempting to do a 1031 Exchange and they are all borne out of the requirement that both properties have the same titling. Because commercial properties are often owned in the name of an LLC or partnership, it is very difficult to keep the same title unless all members agree to proceed with the exchange. Below are three potential issues that can arise with multiple owners.
Alignment of Interests
When it comes time to sell a property and it is clear that a profit is going to be made, each individual who has an ownership interest may have competing ideas about what to do with it. Some may need to take the profit and use it to pay for a college education or medical bill. Others may want to reinvest their profits into a new property with a 1031 Exchange.
The bigger the ownership group gets, the more difficult it may be to align everyone’s interests. If there are two or three people, it may be possible. But, a large syndication can have 100 people, which is much more difficult.
Limited Liability Company (LLC) Partnership
An LLC partnership has the same alignment of interest issue, but it is further complicated by the legal structure that surrounds it. If even one person drops out, they have to find someone to purchase their shares, which is easier said than done.
Corporations and Shareholders
Again, the same alignment of interest challenges arises with a corporation because they can have tens or hundreds of shareholders. Typically, the corporation that owns a commercial property is not publicly traded so it can be difficult for one or more investors to sell their shares and cash out of the deal.
So, given these issues, the next most logical question is, how can a 1031 Exchange be completed in spite of them?
The key to a 1031 Exchange with multiple property owners is an ownership structure known as “tenants in common” or TIC for short. In it, each individual owns an undivided fractional interest in the investment property, not shares in a LLC or partnership that owns it. This distinction is very subtle, but important for legal and 1031 Exchange purposes.
So, the short answer is, to complete a 1031 Exchange with multiple property owners where some want to do it and others don’t – the key is to transition the ownership structure to tenants in common through a strategy known as a “drop and swap.”
How Does a Drop and Swap Work?
In short, a drop and swap exchange is a type of transaction where the partnership or LLC is first dissolved and proceeds are distributed to each individual owner in proportion to their share of ownership using the tenants in common structure. Once complete, each individual owner is free to do whatever they want with their interest – including entering into a 1031 Exchange.
With a bit more detail, the steps to complete a drop and swap are below:
- Before selling the relinquished property, the partnership distributes the property to each of its partners in proportion to their share of ownership using a tenancy in common (TIC) ownership structure.
- Once complete, individuals are co-owners with a fractional interest in the property rather than owning a share in a partnership that owns the property. This is the “drop.”
- Once the distribution is complete, individual partners/shareholders are free to go their separate ways with regard to the property – including exchanging their interest in a 1031 Exchange. In such a scenario, they work with another individual looking to join the Tenants in Common ownership structure and “swap” their interest for cash.
Once the swap is complete, the 1031 Exchange is complete, all IRC rules are complied with, and the co-owners get to go their own separate ways depending on their own individual interests.
To ensure that everything goes smoothly, it is a best practice to work with a Qualified Intermediary and/or CPA who are experts in the tax code regarding these types of transactions. They will help guide the multiple owners through the deal from beginning to end.
Summary of 1031 Exchanges on Properties with Multiple Owners
A 1031 Exchange transaction is a type of commercial real estate investment deal that allows investors to defer capital gains taxes on the profitable sale of an investment property if they reinvest the proceeds into a new property within a certain time frame.
For real estate investors, one of the requirements of a 1031 Exchange is that both the sold property and the purchased property have to be titled in the same way.
For single member LLCs, this requirement is a non-issue. But, a multiple owner scenario may become problematic when some owners want to do the exchange and others don’t.
The main workaround to this issue is a transaction strategy known as a drop and swap, where the property is distributed to co-owners through a tenants in common structure. Then, each owner can “swap” their interest with another investor who wants to join the ownership structure.
To help facilitate this complex transaction, it is always a best practice to work with a Qualified Intermediary and/or CPA.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.